Bailouts Are Not the Solution: Market Pro

Gemma Godfrey, Chairman of the Investment Committee and Head of Research at Credo Capital Plc.

Published 10:15 AM ET Thu, 29 Sept 2011
CNBC.com

As the sovereign debt crisis worsens, there is still a lack of a long term solution. Current rumors center on Europe extending their ability to bail out periphery economies.However, politics and implementation issues pose a significant challenge.As Greece has shown, so far these bailouts haven’t worked, and with debt burdens rising and problems spreading to the core, the situation is only getting tougher.

Using debt to solve a problem of debt is not a valid solution. Greece will fail to meet the deficit reduction targets set at the time of their first bailout and more worryingly will not be able to meet obligations past October 10.

It can’t technically default until it misses a bond payment, the next of which is due in December, but it will soon be unable to afford salaries and pension payments.

Therefore the Greek Prime Minister George Papandreou's claim that they will meet all commitments is just further damaginghis credibility.

Rumors are circulating that to tackle this, and other potential defaults, Europe will extend its funding capacity for further bailouts from 440 billion euro ($600 billion) to 2 trillion or even 3 trillion euro (to be able to comfortably cover Italy).

However, there are immense hurdles to overcome. Politically we are far from consensus. In Germany, three-quarters of the population oppose providing any further funding and the Spanish Economy Minister has asserted that this strategy is “not on the table”.

With respect to implementation, it is unclear how this can be structured without jeopardising the credit ratings of those contributing to the fund.

Crucially, bailouts do not address the root of the problem - growth. As debt burdens increase, without growth they become ever harder to tackle.

Gemma Godfrey

Instead the austerity measures being called for by governments are hurting growth and as the downgrade of Italian debt showed, weak growth can be used to support the view debts are unlikely to be repaid. Portugal predicts it will stay in recession for two years.

Most worryingly, this weakness is spreading to the core with France and Germany stagnating. There is a huge mismatch of interests. Although politicians have waxed lyrical about reigning in spending, economies have contracted.

The situation is only getting tougher. Investors, with less faith their money will be repaid, are demanding more to lend to peripheral Europe. Spain and Italy have to pay over 5 percent in interest to take out longer term loans.

This is the case despite the European Central Bank spending 15 billion euro in one week alone to purchase these bonds, boost demand and bring rates down.

Furthermore, in the case of Greece, the government is losing their popularity.With more unpopular measures to be passed in order to meet bailout requirements, the risk of an early election and political turmoil increases.

Contagion risk is high. Although government moves are highly criticised, doing nothing could spark a market meltdown. Even though Greece only contributes 2.5 percent of EU GDP, its debt is held by many large European institutions.

French exposure is estimated to be as high as 65 billion euros and Commerzbank saw their entire Q2 earnings wiped out by a 730 million euros Greek debt writedown.

Time is running out and the pressure is increasing for ministers to find a long term solution. Until that time, when clarity returns and investor confidence is regained, we’re in for a bumpy ride.

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Gemma Godfrey isChairman of the Investment Committee and Head of Research at Credo Capital Plc.